Saturday, March 01, 2014
9:19:07 PM EDT

European Turbulence

by
Jim Brown

News of a Russian military incursion into the Ukraine caused a sharp drop Friday afternoon.

Market Statistics

The major indexes with the exception of the Dow hit new highs on Friday morning and were holding those gains until they hit an air pocket Friday afternoon. News of Russian military seizing two airports in Crimea and the unexpected announcement that President Obama would speak an hour later knocked the Dow down from a high of +125 at 1:40 to a loss of -46 points at 3:10. Cooler heads prevailed and traders bought the dip to push the Dow back to a gain of +49 points.

The S&P crashed back from a new intraday high at 1,867 to trade under prior resistance at 1,847 before rebounding to close at a new high at 1,859.

The Nasdaq has led the major indexes on the way up and hit a 14 year high at 4,342 intraday but crashed back to 4,275 a -67 point drop before rebounding to close at 4,307 and a loss of -11 points.

The press conference was calm with President Obama warning Russia that military intervention in the Ukraine would be not be without ramifications. Obama said "The U.S. will stand with the international community in affirming that there will be costs for any military intervention in Ukraine." Also, "Throughout the crisis, we have been very clear about one fundamental principle: The Ukrainian people deserve the opportunity to determine their own future."

The statement was a hollow warning and done more for posturing than for effect. The U.S has no capability and no intentions of intervening in the Russian move into Crimea. Vladimir Putin knows that nobody can intervene and he can do whatever he wants. He does not care what America or Europe thinks about his actions. Russia has a major deep water military port at Sevastopol in Crimea and has the right until the year 2042 to transport troops into Crimea to that port.

About the only thing President Obama can do is skip the G8 meeting scheduled for Sochi this summer and refuse to negotiate on deeper trade and commerce ties that Russia is seeking.

The headlines may have created some turbulence in the market but the outcome of the events in the Ukraine will have zero impact on the U.S. and short of tough talk there is nothing the U.S. can do about it.

The Ukraine requested an emergency meeting of the U.N. Security Council over "events that threaten the territorial integrity of the Ukraine." The Council held a closed door meeting on Friday and it was also ineffective against the Russian incursion. The result of the meeting was a statement saying "Support was expressed for the unity, territorial integrity and sovereignty of Ukraine. The Council agreed that it was important that all political actors in Ukraine exercise maximum restraint and called for an inclusive dialogue recognizing the diversity of the Ukrainian society,"

I am sure Putin was struck with fear over the strong language of the statement. NATO leader Anders Fogh Rasmussen pleaded with Moscow "not to take any action that can escalate tension or create misunderstanding". Putin has mobilized 150,000 troops and put them on armed exercises and I doubt he is concerned with the plea from NATO.

We learned late Saturday that the Russian Parliament has given unanimous approval for military action. Since Russian troops were already landing in Crimea on Friday I would say that rubber stamp was a tad late. Russia sent 6,000 additional troops into the Ukraine over the last 24 hours.

Ukraine is in dire financial shape since Putin halted $15 billion in aid when the crisis began. Cash withdrawals from banks were capped last week at the equivalent of $1,400 per day and central bank reserves have shrunk to less than $18 billion. Ukraine's total GDP is only $176 billion, 54th in the world, and they are begging Europe, the IMF and the West for $35 billion in immediate aid to stave off financial defaults. They will probably receive some aid but nothing near that size. Ukraine is in trouble territorially, politically and economically. They will continue to make headlines but nobody is going to war to rid them of the Russian troops. The market will eventually ignore future headlines once investors understand it is a lost cause.

Switzerland, Poland and the U.K. have frozen more than 20 bank accounts belonging to deposed president Yanukovych and his son worth billions of dollars. Ukraine has been called poor as Paraguay and as corrupt as Iran.

While on the subject of Russia most people don't understand that Putin appears on track to refight the Cold War. He was head of the KGB and most believe he is frustrated that Russia lost. Now that he is in charge of the country he is expanding Russia's military reach. Russian Defense Minister Sergei Shoigu told reporters last week that Russia is planning on building permanent military bases or sharing existing facilities in Vietnam, Cuba, Venezuela, Nicaragua, the Seychelles, Singapore and several other countries. Currently they only have one foreign base at Tartus in Syria. Shoigu told reporters Russia was close to signing the relevant documents with the host countries. Negotiations are also underway to establish remote ports for visiting warships and the opening of refueling sites for Russian strategic bombers while on patrol. Vladimir Putin wants to be remembered as the man who restored Russia to its proper place as a world power. According to British consultancy HIS Jane's Russia's defense spending has doubled since 2007 and will have tripled by 2016. So, why is it that President Obama is trying to cut the U.S. military back to 1940s strength levels when Russia is rapidly expanding its global presence?

The markets rallied at the open after the Q4 GDP revision was not worse than expected. Expectations were for a revision from 3.23% growth to 2.3% and the headline number came in at 2.38% so everyone was happy. We will be lucky if the Q1 GDP is even half of that number but that is a story for another day.

The downward revision came from a smaller contribution from inventory accumulation than previously expected. The contribution from inventory growth declined from 1.67 points in Q3 to 0.14 in this revision. Growth accelerated in Consumer spending, nonresidential investment and exports while federal government spending and residential investment declined.

For all of 2013 GDP grew +1.9%, down from +2.8% in 2012. This came from reduced growth in business investments, slower spending on consumer services and a decline in government spending as a result of the sequester.

Pending Home Sales recovered in January with the index rising +0.1% to 95.0 from 94.9. In December there was a -5.8% drop in sales. January was the first month since June that the home sales index actually rose. However, we can't blame the weather for the continued weak showing in January since sales in the Northeast rose +2.3% and the South +3.5%. The Midwest declined -2.5% and the West -4.8% where weather was not a factor. Home sales are now down -9% from January 2013. Sales in the West are now -17.5% below year ago levels. Sales should improve in March when the polar vortex is behind us.

The final revision on Consumer Sentiment rose slightly from the 81.2 in the last report to 81.6. The expectations component rose from 71.2 to 72.7 and the present conditions component declined slightly from 96.8 to 95.4. This report was ignored.

Mortgage applications declined -8.5% over the prior week to push the Mortgage Purchase Index to the lowest level since 1995. Of course analysts blamed the weather. If it is just a weather related blip then we should see applications pick up significantly in March.

Chart from CNBC

Late Friday night the Chinese Purchasing Manager Index (PMI) for February came in at 50.2 and an eight month low. This compares to the 50.5 in January and a 50.1 consensus estimate. This suggests the challenges in China are continuing to weigh on the economy. The Yuan declined the most on record in February losing nearly -1% on Friday alone and that also suggests the economy is in trouble and vulnerable to financial risks. However, the falling Yuan is positive for overall growth and makes exports even more attractive. Most analysts believe China is letting the Yuan fall to gain that competitive advantage in the global markets.

The economic calendar for next week is busy and there are multiple reports of consequence. The first is the national ISM manufacturing on Monday, which is expected to be flat at 51.6 and barely into expansion territory. However, there are some whisper numbers in the low 50 range and we could see a negative surprise.

The next major report is the ADP Employment on Wednesday. The ADP report is generated from data from more than 400,000 companies and tends to reflect the final revisions of the Nonfarm Payroll data. Last month there were +175,000 new jobs in the ADP report. Analysts are pretty neutral on the estimates for February with expectations for ADP employment to come in the same as January.

The government's Nonfarm Payroll report on Friday is expected to show a gain of +165,000 jobs, up from +113,000 in January. That January number is expected to be revised higher. While the Yellen testimony on Thursday was the cloud over the market the first three days of the week the Nonfarm Payroll report will be the cloud next week. However, if the ADP report comes in higher than expected we could see a market surge as analysts revise their Nonfarm estimates higher.

The Fed Beige Book on Wednesday will also be important since this is a report on economic activity across all 12 Fed districts. The last report in January covered the late November to early January period and several districts reported slowdowns due to severe weather. I expect that has not changed and weather will be the common excuse for any weakness in the report.

There are several speeches by Fed heads and some data points from overseas. The BoE and ECB will announce their rate decisions and no changes are expected by the BoE but there are some hopes the ECB will cut rates. Inflation is shrinking rapidly in the Eurozone and could be headed for deflation. Even Germany is seeing falling inflation and that could push the ECB to act on Thursday. The Draghi press conference after the ECB decision is probably the focal point for Europe on Thursday.

Two Fed heads speaking on Friday were almost dovish. Charles Evans stressed the Fed is planning on overshooting the 2% inflation threshold. He said "We need to repeatedly state clearly that our 2% objective is not a ceiling for inflation." The current Fed guidance is for no rate increases unless inflation exceeds 2.5%. Evans said, "It is less clear to the public that we should be willing to overshoot our objectives in order to speedily reach our goals." The Fed believes that letting inflation rise will accelerate job growth.

Charles Plosser speaking at the same event said the Fed was wrong in setting specific guidance saying the current thresholds have lost their meaning. The Fed said they would consider raising rates when the unemployment rate declined to 6.5% but after that guidance the rate fell sharply but not for the right reasons. The falling labor force participation rate caused the unemployment rate to plunge despite continued sluggish job creation. The unemployment rate is currently 6.6% but over the last 12 months we have only averaged job gains of +188,000 per month and it takes +150,000 just to accommodate new workers entering the labor force from graduation and immigration. That means actual unemployment only declined by 456,000 for the year.

Yellen said on Thursday that the Fed should refrain from raising interest rates even if unemployment dropped well below the 6.5% level. She also said the Fed was looking at changing the guidance for the 6.5% and 2.5% objectives.

In stock news the never ending story of the Men's Warehouse (MW) Joseph A Banks (JOSB) merger added another chapter on Friday. JOSB again declined the MW offer of $63.50 per share BUT said it would be willing to enter into talks with MW over a fair acquisition price. Reportedly MW has said they could raise their offer to $65 if JOSB will provide them accounting information.

JOSB asked MW to provide specific details of what they would be looking for in the form of due diligence prior to a meeting. JOSB also said it wanted MW to get a transaction preapproved by the FTC since the agency has already asked MW how it will avoid reducing competition.

MW replied to JOSB saying it would prepare a due diligence list and "take all measures to assure that a merger will meet regulatory approval." Since MW is also in the process of acquiring Eddie Bauer for $825 million the lack of post merger competition question is only going to intensify. I just wish they would get on with the deal so there will be one less company advertising "buy one suit, get two free" on the cable TV channels.

Sotheby's (BID) said the buyer of the 59.6 carat flawless pink diamond in November for $83 million defaulted on the payment. The internally flawless stone was "one of the most remarkable gems ever to appear at auction" according to Sotheby's. Unfortunately New York based diamond cutter Isaac Wolf defaulted after his mystery buyer refused to pay for the stone. Auction houses sometimes have to guarantee the sale of a high dollar item in order to induce the seller to place the item with them. In this case Sotheby's had to pay the seller and assume responsibility for the diamond. The auctioneer said it added the item to its inventory with a value of $72 million and they were thrilled to have the diamond in inventory and were comfortable with the valuation. They are currently in talks with the original buyer while considering other alternatives. If you want your significant other to have the ultimate status symbol you might be able to acquire it at a discount to the $83 million auction price.

59.6 Carat Pink Diamond

Shares of Deckers Outdoor (DECK) declined -12% on Friday after the company warned they were expecting a Q1 loss of about 16 cents. Analysts were expecting a profit of 11 cents. Deckers said they opened 28 stores in the last half of the year and the costs would weigh on profits in the first half of 2014. However, they expected the second half to produce strong gains with a 9% increase in Ugg revenue for the entire year. They now have 101 stores globally. A Sterne Agee analyst said he does not understand how an expected double digit increase in online and retail sales and a mid-single digit rise in wholesale sales will lead to only a 9% gain in Ugg revenue for the year. Several analysts downgraded the stock after the confusing guidance.

Decker's reported earnings on Thursday of $3.80 that beat estimates by 24 cents. Revenue of $736 million also beat estimates. Going from $3.80 in earnings in Q4 to a 16 cent loss in Q1 is a major change. That is especially true given the cold weather and the implied demand for Ugg boots.

Sub sandwich maker Quiznos with 2,100 stores is said to be preparing a bankruptcy filing according to the Wall Street Journal. This comes two years after a previously agreed out of court debt restructuring deal. The company has been negotiating with creditors for several weeks but has been unsuccessful. Quiznos is different than some other franchises because it not only requires store owners to pay a fee for the use of the name but also requires them to buy their food and supplies through the Quiznos distribution business, which charges them more than what they would pay from other suppliers. Quiznos is not a public company.

Italian restaurant chain Sbarro, a major fixture in mall food courts, is also preparing for a bankruptcy. The pizza chain is struggling with declining mall traffic and competition from other stores. Higher costs for ingredients like cheese are also a problem. Mall food courts have turned into a battle ground for the shrinking consumer dollar. The chain announced plans to close 155 stores. They currently have more than 800 stores in 40 countries and opened 81 in 2013. Sbarro filed for bankruptcy during the recession and exited that bankruptcy in 2011 by turning ownership of the chain over to the senior lenders, which were owed $176 million. The company is likely to file chapter 11 so it can renegotiate or terminate leases on stores that are unprofitable. Sbarro is also private.

The food court chain Hot Dog on a Stick also filed bankruptcy in February. The retail picture in America is changing rapidly. Mall traffic is dropping fast and typical mall stores and restaurants are closing locations at a rapid pace. Online shopping is gaining acceptance and only those stores with rapidly changing merchandise that cater to the younger crowd are still successful.

On Friday Pier 1 (PIR) cut guidance for Q4 from 47-52 cents to 40-41 cents compared to analyst estimates at 51 cents. Revenue guidance was $512.5 million compared to estimates of $541 million. Same store sales are now expected to be flat. The company also lowered its 2014 outlook to $1.01 compared to estimates for $1.12. They blamed the drop in profits on ... you guessed it, the weather. Shares declined -6% to a 52-week low.

The Gap (GPS) warned that full year earnings would be $2.90-$2.95 compared to analyst estimates for $3.02. Q4 profits of 68 cents beat estimates by 2 cents but revenue declined -3.2% to $4.58 billion. The CEO said it was a tough holiday season and they were faced with cutting prices to the bone to draw customers into the mall. They said 2014 had started off slow because of the "weather." We need to get used to hearing that excuse because everybody is going to be using it. Shares of GPS were flat thanks to a 10% increase in their dividend.

I am sure you have heard about the new trend for marijuana legalization. Everybody wants to know how to get into this sector and capitalize on what could grow to a multibillion dollar market. For obvious reasons there are very few public companies in the space. The Federal government just relaxed the banking rules over the last couple of weeks so pot stores could deposit their cash without fear of having it confiscated.

Several penny stocks have appeared but investing in those could be dangerous to your health. I am talking about Hemp Inc (HEMP), Cannabis Science (CBIS), Growlife (PHOT) and Medical Marijuana (MJNA). These stocks have seen their shares rally strongly over the last couple of months but all are shrinking as the news headlines fade.

The largest market cap in the sector is Medbox (MDBX) a maker of drug dispenser equipment. Medbox makes pharmacy grade locking dispensers that can handle controlled substances like marijuana and nearly any drug in pill form. Think of it as a combination safe and vending machine for drugs. They just announced a specific machine for dispensing marijuana called the Secure Safe. The dispenser has its own point of sale terminal that only operates through pass codes and a fingerprint scanner. Only authorized operators can dispense products or access the internal inventory. Since early December MDBX shares have traded from a low of $8 to a high of $93.50 and is back down at $27 today.

Short seller Citron Research was responsible for the big decline when it launched a major attack on Medbox claiming systemic fraud, stock promotion and accounting irregularities. If Medbox can get past those claims it might have the best chance of a future return since it actually makes a real product and the demand for secure dispensing applications is growing.

This is truly a case of buyer beware when trying to invest in the marijuana industry in any form. If you are going to speculate in this sector keep your positions small.

Bitcoin exchange Mt Gox filed bankruptcy in Japan on Friday. I reported on their problems last week and the bankruptcy filing claims they lost 744,000 bitcoins belonging to customers and 100,000 of their own due to cyber theft. The loss at today's value is roughly $500 million and they listed assets of about $50 million. At this point any customer with bitcoins stored at Mt Gox is out of luck.

The Las Vegas Sands (LVS) said customer data was stolen from the Pennsylvania property in a cyber attack. The information included social security numbers, drivers license info and credit card data. The number of accounts compromised were in the tens of thousands. The Sands had been the victim of a directed attack in February where pictures of burning casinos had been posted on their website and a YouTube video disclosed the usernames and passwords of employees along with critical information about the structure of their computer network.

Sears Holding (SHLD) said the Secret Service was investigating the possibility of a data breach at Sears similar to the ones at Target, Neiman Marcus and Michaels. Sears claims they have no evidence of a breach at this time but their systems are being investigated.

United Continental (UAL) said the cancellation of 22,500 flights in Q1 would reduce earnings. The revenue for each seat mile will drop by -0.5% to 2.5%. Skyline research said the storms were an "ugly outcome" and they increased their estimate for a quarterly loss from 62 cents to $1.46 per share.

It was an interesting week in the markets with a constant struggle at resistance until after Yellen's testimony. The early part of the week saw a pattern of early morning gains followed by late afternoon selling. Thursday was out of context with the market rising after the Yellen testimony. The S&P closed at a new record high at 1,854 and in theory a new leg higher had begun. Friday's early gains took the S&P to 1,867 and the bulls were ecstatic. The invasion of the Ukraine and announcement of the president's press conference were "blamed" for the afternoon decline.

However, Friday was the last day of the month and for the last eight months we have seen declines on the last day. Analysts attribute this to funds balancing the books after a month of strong gains in equities. February posted the strongest gain in equities since July mostly because the lows for the month were on the 5th after a sharp decline in January.

The S&P rebounded at the close to end at 1,859, a new high close, and well over the prior resistance at 1848-1850. In theory this should be the start of a new leg higher and the target for traders is now 1,900. Support is still 1,840. The risk is a reaction to the Ukraine invasion when the market opens on Monday.

Historically the first two weeks of March are weak but every year stands on its own based on current events. Earnings are over and economics will be the focus with the ISM and payroll reports.

The Dow rallied +125 at the open only to trade to a -46 point loss on the afternoon decline. The rebound of nearly +100 points was encouraging. The Dow closed above the highs for the last two weeks but still well below the prior highs in December at 16,576. Resistance is 16,450 and then 16,500. The Dow has been lagging the other indexes but maybe the trend is about to change. Support is 16,150.

The Nasdaq has been the leading index in the February rally. It is now up +3.15% for the year while the Dow is still down -1.54%. The strong gains in tech stocks over the last month led to strong selling Friday afternoon as investors took profits on the last day of the month. In the table below the majority of the names in the loser column were the momentum leaders for the month.

I would not attach too much importance to the sharp decline that left the Nasdaq in negative territory at the close. I view this as simply taking some money off the table ahead of a lot of uncertainty from Ukraine over the weekend.

The decline knocked the Nasdaq back to 4,275 and support for the last week. The dip was immediately bought but just not in enough volume to lift the Nasdaq back into positive territory. The Nasdaq is struggling to move over the longer term uptrend resistance lines in red on the chart. The upper trend resistance is now 4,365.

The Russell 2000 finally broke out to a new historic high and is now up +1.67% for the year. The next resistance is just over 1,200 and that would probably be about the limit for Russell gains without a decent retracement for profit taking. The Russell is up about 111 points from the February low of 1,082 to the Friday high at 1,193. That is roughly 10% in less than a month and is begging for several days of profit taking at that next resistance level. Short term support is 1,177 followed by 1,172.

I believe there is nothing keeping us from moving higher but there may be a knee jerk reaction to the Ukraine situation on Monday. As I explained earlier there is nothing the U.S. can do about it except fire sharply worded sound bites at Putin. Once investors realize we are not going to war over the Ukraine they will buy the dip.

Just remember the normal seasonal weakness in the first two weeks of March. It may or may not appear but we should be ready for it. I would buy any drop to support. The market could be listless ahead of the payroll reports but either outcome is good. Either jobs will be strong and the economy recovering from the winter weather or jobs are going to be weak and analysts will blame the winter weather. Either way the market should rebound on the realization that winter is almost over.

Random Thoughts

Is the current stock market overvalued? We hear it constantly in the press that the market is currently trading at XX times earnings and the XX changes depending on who is talking. Comstock Partners believes it is very overvalued and here is their editorial for the week.
The Market Is Significantly Overvalued

The IRS released some "Health Care Tax Tips" last week warning Americans they must obtain "qualifying" insurance or face a "Shared Responsibility Payment" when they file their 2014 taxes next year. Once Obamacare is fully implemented the "individual mandate tax" will rise from the current $285 per family to be a maximum of 2.5% of Adjusted Gross Income or $2,085 per year, whichever is higher. That means everyone (you and your dependents) without qualifying insurance will pay a minimum of $2,085 per year. For every month of the year you were not covered you will have to pay 1/12th of that tax.

Warren Buffet released the letter to shareholders this morning. The letter is a "must read" for many people and Berkshire Hathaway shares normally rise on the Monday after the letter is released. Berkshire made two large acquisitions in 2013 with Heinz and NV Energy. Less reported were the 25 acquisitions made by Berkshire companies. You can read the letter here. Berkshire 2013 Results